Euro crisis builds towards early November crescendo

The markets have taken the absence of bad news out of Berlin to go into euphoria mode. But the downside is only a moment’s realization away, and the big issues are still ticking away, with a 3 week timer now in place. Hang on for the ride.

The outcome of the meeting between French President Nicholas Sarkozy, and German Chancellor, Angela Merkel, to try and reach a common position on the future of the Euro debt crisis, has been to set an end of October deadline for a comprehensive package.

The bilateral summit in Berlin saw little by way of concrete commitments, apart from the German Chancellor’s, “We are determined to do whatever is necessary for the recapitalization of our banks”.The pair made no comment on whether the €440 billion European Financial Stability Facility (EFSF) will underpin that recapitalization need or whether it would be national treasuries. They also flagged EU Treaty changes to further economic integration proposals which would come at the Eurozone summit in late October, and said they were waiting for a report from the IMF, EC, and ECB troika on handling the Greek crisis.

The likely need for bank recapitalizations and who will provide the funds, remains the key political stumbling block for an agreed forward plan, with key German political figures pushing for a nationalization of crippled banks rather than bailout.With the need for bank recapitalization largely depending on the size on any haircut private investors need to take on Greek debt, there was no announced agreement, with Germany believed to be pushing for a larger, up to 60%, haircut, and the French believed to be looking to keep it close to the 21% generally agreed in the existing Greek bailout plan.

Without answers to these issues there is no certainty for the markets whatsoever, despite their Monday euphoria, which is largely attributable to the prospect of having at least a clear plan on the table in 3 weeks time.The downside is that it may just be a desperate scramble.The 6 day delay in the Eurozone summit smacks of the need for some intense lobbying somewhere.Don’t be surprised if some turn up in Cannes, just a little sensitive.

The package that will be unveiled in Cannes needs to do 3 key things

Time and manage the fallout from a Greek default, and prevent contagion from affecting Portugal Ireland Spain Italy, etc etc etc.

The key issue here is the size of the haircut for Greek debt holders.It was painfully obvious from the time it was announced that the 21% haircut envisaged in the summer for private investors in Greek debt, was not going to be enough.The markets love certainty, but the only certainty that proposal provided was the certainty that it was not enough.With the certainty that Greece will default, the issue becomes one of making sure that its default will not trigger defaults elsewhere – a very live risk at the moment with 2 year Portuguese debt reaching 17% earlier this week.That means working out a haircut for private holders which is realistic in terms of providing relief to Greece, but which doesn’t massacre the balance sheets of the European banks – in particular – which are significant holders of Greek debt.The size of the haircut is highly likely to determine any possible flight from other endangered Eurozone sovereigns.The bigger the haircut the more likely investors will decide that there is no safety in sovereigns, potentially triggering a capital flight from Ireland and Portugal, which have been bailed out and could in extremis be propped up further, but also Spain and Italy which are generally seen as too big to bail out and have seen their yields climbing to record highs of late.If they go higher the contagion

Ensure that Banks are capitalized sufficiently to manage that default.

As has been highlighted time and again over the past 2 years, a number of European banks are woefully undercapitalized.Recent date shows from the euro Banking association shows that only 7 of 21 leading Eurozone based banks have a better Tier 1 capitalization ratio than they did in 2010 .The sentiment surrounding European banks in general, but of late particularly French banks, has seen the share prices of major French lenders hammered since the start of the year.Depending on the size of the haircut imposed on Greek debt holders, particularly for Spanish and Italian banks, estimates as high as 400 billion Euro are in play.

How to capitalize those banks is a question that a tentative agreement seems to be in sight, with consensus drifting towards National government providing a backstop role where the institutions can’t raise the capital on the markets.Their ability to raise capital on the market will reflect how genuine markets see the haircut likely to be imposed on Greek debt holders, with attendant implications for holders of other sovereigns.

Come up with some economic stimulus to generate economic growth across the Eurozone.

Beyond the banks and the sovereigns there are the national economies that support them, and they are in ugly shape.2Q GDP data showed that the powerhouses of the Eurozone, France and Germany, had ground to a halt, with most of the rest either in outright recession, or hanging on for dear life.The problem is that the capacity of much of the Eurozone to fund any stimulus at all is limited to either none – Greece, Portugal, Ireland, Spain, and probably Italy – or is likely, in conjunction with any need to contribute to bailouts for banks to lead to severe risks of aggravating the sovereign issues.

Beyond the haircut there is what else the ECB will be in a position to do to support liquidity, and how it plays the economic slowdown in terms of monetary policy and interest rates.If it continues to set interest rates with an eye to Germany, it will consign some of the peripherals to long term economic stagnation, if not aggravating the sovereign and banking issues by triggering further contraction. It will be interesting to see if there is any reversal of its position on haircut size under new president, Mario Draghi.

Any package of measures that doesn’t address all of these will simply leave the Eurozone open to further downside. Failing to square off all of the above issues, especially now that the comprehensive package has been promised, promises meltdown. After two years of arguably over promising and under delivering, It's time to deliver.